Chapter 1: Major puzzles and anomalies
Exchange rate economics is characterized by a number of anomalies, or puzzles, which we struggle to explain on the basis of either sound economic theory or practical thinking. Put more simply, the international finance profession has not yet been able to produce theories and, as a consequence, empirical models which allow us to explain the behavior of exchange rates with a reasonable degree of accuracy. (Sarno 2005a, p._2) This book points out 16 puzzling facts and/or anomalies about exchange rates and reviews many attempts to explain them. It also synthesizes and extends previous theoretical work in this area. The book focuses on two well-known ideas in the uncovered interest parity (UIP) literature, namely the existence of one or more missing variables in the so-called Fama regression, and the possibility that the fx market is, at least at times, inefficient. The theoretical portions of this book utilize the intertemporal approach to UIP, as in Gourinchas and Tornell (2004). This book does not “start from scratch” and develop a totally new theory. Rather, it draws from the work of many scholars. This leads to two “synthesis models,” one with the assumption that ex ante UIP holds at the end of each time period, and the other allowing for the possibility that the exchange rate does not change enough in any one time period to satisfy ex ante UIP. In addition, a UIP framework with regressive expectations is developed and shown to be consistent with many puzzling facts.
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